Economic damage from Brexit will incentivize the UK to go for a "soft-out" deal, Morgan Stanley said.

A hard Brexit could see a 7.5% fall in GDP.

LONDON – Two Morgan Stanley analysts believe that the scale of the potential economic damage Britain would suffer as it leaves the EU will force the country to accept a "soft out" deal in which the UK economy stays largely aligned with Europe's.

The research note, by analysts Jacob Nell and Melanie Baker, largely parallels the leaked government analysis from the Department of Exiting the European Union, which forecast that GDP growth would be reduced by 8% with no deal, reduced by 5% with a free trade agreement, and reduced by 2% if the UK remained a member of the European Economic Area.

Morgan Stanley created this chart, showing Britain's a la carte Brexit options and the economic damage each one would cause:

Morgan Stanley

Each position is summarised by an estimate of the long-term economic damage.

Possible post-Brexit status, and the percentage hit to UK GDP:

WTO/No deal/"Hard Brexit": -7.5%

Free Trade Agreement/"Canada-Plus": -6.2%

Stay inside customs union: -6.2%

Swiss-style bespoke relationship: -6.2%

Retain EEA Membership: -3.8%

Staying in the EU (baseline): 0%

In each of those scenarios (except staying in the EU), the hit to growth would be greater than Britain's current annual GDP growth. That will force Prime Minister Theresa May's government into a soft Brexit, Morgan Stanley argues:

"... the decisive moment for the talks is in late 2018, when we think the UK faces a choice between a hard Out, where the UK takes back political control from the EU but faces major barriers to trade, or a soft Out, where the UK continues to some extent to pool sovereignty with the EU and participate in the single market and customs union. After the preliminary withdrawal agreement, we now think the most likely outcome is a transition period to 2021 involving minimal change in the trading regime, allowing time for further trade talks. We now see a high likelihood of a low-disruption transition period, a lower risk of a WTO outcome, and a better chance of an eventual soft Out."

Nell and Baker, who published their note earlier this month, believe that it is logistically difficult to get a "hard Brexit" even if the government wanted one, because doing so might reignite the conflict in Ireland over the border between Northern Ireland and the rest of the country:

"First, the parties have reached preliminary agreement on the exit issues [in December], setting a constructive precedent. Second, the parties are now discussing an option that includes a transition period that avoids major changes in UK-EU trade until 2021 and an ultimate trade deal that builds on a Canada-style free trade agreement, with the Commission proposing to extend it to judicial cooperation, aviation, security and foreign policy and with the UK, including Chancellor Hammond, proposing to extend it to financial services. Third, a hard Brexit would create a problem with the Irish border. The UK government's promises that there will be regulatory alignment between the Irish Republic and Northern Ireland and no new regulatory barriers between Northern Ireland and the rest of the UK implies that there would be an Irish border issue if the UK seeks meaningful divergence from the EU. In short, it looks hard to satisfy the promises on the Irish border with a hard Brexit, while breaking them would run the risk of the talks breaking down, and precipitating a no-deal outcome."